Earnouts in M&A: Getting Paid for Performance

Few deal terms in a merger or acquisition are as crucial, yet contentious, as the earnout. In theory, earnouts sound simple. An earnout allows a seller to pay part of the purchase price down the road, depending on whether or not the target company meets certain performance criteria. However, despite their perceived simplicity, these clauses are also filled with minutiae and require extensive expertise to navigate.

Earnouts are becoming more popular in M&A transactions and were featured in 26% of private deals in 2023, up 30% from the year before. They will likely continue to grow in popularity based on the current European M&A outlook for 2025.

For personalized guidance related to earnouts in M&A, we recommend contacting the team at Acquinox Advisors directly. Otherwise, let’s explore the role that earnouts play in mergers and acquisitions. 

What is an Earnout?

An earnout is a risk control mechanism in an M&A deal where a portion of the purchase price is contingent on a certain set of requirements. Most often, the acquiring company pays the majority of the target company’s purchase price upfront, with a promise to pay the rest if certain financial metrics are hit over the next one to three years.

Earnouts are especially common in M&A transactions involving early-stage companies, where there is a larger disparity between realized revenue and growth expectations. They are also common in highly-regulated industries like biotechnology or energy, where government approvals can be the difference between feast and famine.

Let’s explore a quick example of how an earnout works…

Company A, a larger acquirer, is looking to purchase a smaller competitor, Company B. While Company A values the target at $150 million, Company B believes it’s worth closer to $200 million. To bridge the gap and finalize the deal, both parties agree to an earnout structure: Company A will pay $150 million upfront, with an additional $50 million contingent on Company B maintaining its current growth trajectory over the next three years.

Earnouts are usually based on financial targets, with the most common target metrics being Earnings Before Interest, Taxes, Depreciation, or Amortization (EBITDA), revenue, margins, or earnings per share (EPS). However, these deals can take several different forms.

Types of Earnouts

Earnouts can range from fairly straightforward to highly complex agreements, depending on the companies involved. In general, there are six common types of earnouts:

1. Straight-Line Earnout: Earnouts are calculated as a percentage of the target company’s financial performance, and the seller receives a portion of the earnout each year (based on performance).
2. Tiered Earnout: Earnout payments are triggered whenever a performance target is reached, usually with multiple earnout payments.
3. Milestone Earnout: Earnout payments are tied to specific goals. These goals do not have to be financial and can include milestones such as new product launches, securing a key customer, or gaining regulatory approval.
4. Retention Earnout: Earnout payments are tied to specific employees’ continued employment with the company for a set period of time.
5. Equity Earnout: Earnout payments are granted in the form of equity rather than cash.
6. Reverse Earnout: This flips the traditional earnout structure, where the buyer receives a payment from the seller if the target company fails to reach a performance target. A reverse earnout essentially allows the buyer to claw back a portion of the purchase price if the target company underperforms.

That said, let’s explore the pros and cons of earnouts for both the buyer and seller in an M&A transaction.

Pros of an Earnout

For the Buyer

• Reduces Risk: An earnout helps the acquiring company reduce risk by paying a smaller price upfront. The rest of the money is only owed if the target company performs as expected.
• Motivates the Seller: An earnout usually keeps the seller onboard and creates additional incentive for them to continue driving results even after the deal has been finalized.
• Helps Close the Deal: An earnout can be a valuable negotiation tool to help a buyer and seller reach a compromise and finalize a deal, especially when they disagree on the purchase price.

For the Seller

• Increases Total Price: An earnout can help sellers negotiate a higher overall deal value, provided that the business performs well.
• Helps Close Deals: An earnout can help the seller close deals that would otherwise fall apart over pricing disagreements.

Cons of an Earnout

For the Buyer

• Can Create Post-Close Tension: Earnouts can create friction, especially if the seller is required to stay involved in managing the business. Disagreements may arise over the company’s strategic direction or day-to-day operations. There could also be disputes over how performance metrics are defined and measured, as even minor accounting differences can determine whether an earnout is triggered. These factors could make the post-merger integration process more difficult than it already is.
• Require a Complex Structure: Earnouts can be legally and financially complicated to structure and monitor, usually involving legal teams and extensive reviews.
• Can Misalign Incentives: Earnouts can motivate sellers to reach short-term financial metrics, which could jeopardize the long-term health of the business. For example, the seller may switch to a cheaper provider for a key product in hopes of cutting costs, boosting EBITDA, and triggering an earnout. However, the cheaper product quality could damage the company’s brand reputation over the long run.

For the Seller

• Leads to an Uncertain Payout: By including an earnout, the seller links part of their compensation to the business’s performance, which isn’t always in the seller’s control.
• Creates Potential for Disputes: Earnouts are a heavily litigated area in M&A due to how performance metrics are measured and interpreted.  As a result, sellers may find themselves navigating a tense and stressful environment throughout the earnout period, which can last several years.

Final Thoughts: Earnouts in M&A

Earnouts are a powerful and popular tool in M&A transactions that help bridge valuation gaps and move deals forward. But they also carry risks for both the buyer and seller, especially when expectations aren’t clearly defined or performance metrics are open to interpretation.

Whether you’re structuring an earnout or negotiating one, success lies in clear terms, mutual trust, and a shared vision for the business post-close.

Planning to pursue a merger or acquisition in the near future? If so, please contact the team at Acquinox Advisors today for personalized M&A guidance.

We hope that you’ve found this article valuable when it comes to learning what an earnout is in the M&A process – thanks for reading!